Scott Sumner  

What if there is no zero bound problem?

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It seems as though the major central banks are beginning to rethink their assumptions. Here's an ECB official:

Monetary policy risks becoming ineffective in a world where growth is sluggish, economies are deeply interconnected and interest rates are already near zero, a top European Central Bank policy maker said on Saturday.

Speaking at the University of California Berkeley, ECB executive board member Benoit Coeure called for academics and policy makers to address issues at the root of a global economic malaise, singling out the euro zone's inability to revive domestic demand.

"The capacity of the global economy to generate growth is under question," Coeure said in remarks prepared for a speech.

"In a global zero lower bound environment, surplus countries hold world output down."

But then why did the ECB raise rates twice in 2011? And here's a top Fed official:

The U.S. Federal Reserve and other global central banks may need to consider new tools in a world of permanently lower interest rates, including keeping big balance sheets or using negative interest rates to combat shocks, a top Fed official said on Saturday.

With the so-called natural interest rate in the United States now near zero, and equilibrium rates in other countries around the world also lower than in the past, central banks have "significantly less room to maneuver" in the face of recessions, San Francisco Fed President John Williams said at a conference at University of California Berkeley's Clausen Center.

Everyone seems to assume that the zero lower bound is the key problem. But how do we know this? Has the lower bound ever been tested? Not as far as I know.

In standard new Keynesian models, bank reserves and Treasury securities become almost perfect substitutes at the zero bound. And the key assumption is that it's not possible to pay negative interest on bank reserves. Except that it is possible, indeed it's been done.

When economists are confronted with this fact, they point out that commercial bank deposits at the Fed and vault cash are near perfect substitutes, and thus negative interest on reserves would merely cause the money to move out of the central bank and into vault cash. However this doesn't really resolve the issue, as it's certainly technically feasible to pay negative interest on vault cash.

Indeed it's technically possible to pay strongly negative interest on bank reserves, including vault cash. How negative? There is no lower bound.

When economists are confronted with this fact they suggest that sharply negative interest rates on reserves would depress bank deposit rates so low (so far negative) that the public would pull money out of the banking system, and hold it as currency.

That is certainly true, but the important question is how much? Today, banks in the US hold nearly $3 trillion in reserves; what if all of that went into circulation? How about $10 trillion, or $15 trillion? Maybe nothing would happen, it would all go under mattresses, or into safety deposit boxes. On the other hand maybe it would create a Latin American-style hyperinflation. We simply don't know. (I bet on hyperinflation, if the currency stock exceeds $10 trillion.)

I understand all this, but here's what I don't understand---why the lack of curiosity? You are in a prison cell. The door to your cell might be locked, or it might be unlocked. You don't know. But wouldn't you be curious? Wouldn't you try to open the door to see if you could freely walk out into the sunshine? Or would you just sit there, day after day, year after year, wondering? Is it locked?

The world's central banks have chosen to just sit there, wondering. They haven't tried lowering IOR so far negative that all of the bloated base money floods out into cash held by the public. They aren't curious. Nor are academic economists. Why not?

In 2009 the Fed claimed to be worried about the effect of negative IOR on money market funds. At the time, I argued that that worry was preposterous. Now the Fed seems to have conceded that negative IOR is an option---even Janet Yellen has discussed the possibility. That's progress. But we still don't see any central bank fully exploring the possibilities of negative IOR. And that's a puzzle. Although I suppose it's no more of a puzzle than the Fed's reluctance to cut rates to zero in September, October and November 2008. I thought Ben Bernanke's memoir would resolve that mystery, but all we got was an admission that the Fed had erred in not cutting rates after Lehman failed. Yeah, I'd say so, but why is an institution full of such smart people so obviously inept in a crisis? Another mystery.

HT: TravisV, Dajeeps

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COMMENTS (12 to date)
E. Harding writes:

"But then why did the ECB raise rates twice in 2011?"

-Because it felt like inflation was going to soon get way above target. It did.

"They aren't curious. Nor are academic economists. Why not?"

-They're probably afraid people will never again trust the banking system after this.

ThomasH writes:

The basic problem does not seem to be the zlb of short term interest rates. Central banks have already discovered that they can purchase other assets to stimulate the economy. The problem has been fear of committing to a PL target and allowing inflation rates to exceed a self imposed ceiling in order to achieve that target. The same fear stands in the way of committing to an NGDP target.

Scott Sumner writes:

E. Harding, But that policy led to the current situation, where supposedly the ECB is powerless. Why would they want to do that?

Thomas, I agree that they are afraid of doing level targeting. But that doesn't fully explain the reluctance to test the zero lower bound. They are also failing to hit their current inflation target.

Jean writes:

Scott, the madness over in Europe has to do with the way the euro system is constructed. They have 'tier one' and 'tier two' capital, which means that no euros printed in Germany can be used to purchase the bonds of any other country within the eurozone. If you look back at 2008 it was the head of the Bundesbank yelling about 'tier one' capital that preceded the rate hike of July in that year. That is probably also the reason for both hikes in 2011.
The entire spectrum in the US, from Krugman on the left to Feldstein on the right, and of course Friedman, warned the europeans the a currency so constructed could never succeed - and here we are.
Basically, the Germans lost the plot on effective monetary policy in the 90s - the German finance minister recently proclaimed that the euro was NOT too tight because rates were so low!

Emerson writes:

The general public has very little understanding of monetary policy. This is represented in Ben Bernanke's new book.

In the book he recites a conversation he had with the Chairman of the House Financial Services Commitee- Barney Frank- where Mr Frank asks Mr Bernanke about where the Fed gets all its money.

This would be funny if it was not so sad.

And I am sure that the American Public knows less about the Federal Reserve than Mr. Frank.

But it seems as though the American public does -generally- understand inflation. Any Fed policy that would induce noticeable inflation could be politically volatile . Particularly when the unemployment rate is at a relatively low 4,6%.

Granted the current CPI is a mere 0.3%, and the 10 year TIP spread is only 1.5%, and it would take some time for any new policy to achieve the implied 2% CPI target.

I am just making the point that policy makers fear the political backlash of inflation more than they fear the backlash of slow GDP growth - again- particularly when the unemployment rate is only 4.6 %

Emerson writes:

I am not so sure I can see what the "mystery" of FOMC activity was during 2008.

In Aug 2007 the Fed funds target was 5 1/4%. By Dec. 2008 it was 0%.

FOMC Jan 2008-Fed Funds target - 3%

FOMC April 2008 - Fed Funds target reduced to 2%

FOMC Aug 2008 - Inflation was 3.5%. Bill Dudly led a FOMC discussion of how the liquidity created through Fed lending could impair the FOMC ability to hold the 2% Fed funds target. In fact the FEd had resorted to selling treasuries off its balance sheet in an attempt to sterilize the liquidity created from lending. The Fed was actually a bit worried that its balance sheet would actually run out of treasury securities to sell!

In retrospect - maybe this sterilization was a mistake..

FOMC Sept. 2008- Inflation was 5.4% - up from 3.5 %, unemploymnet was up to 6.1% from 5.7%
Fed Funds rate held steady at 2%

FOMC Oct 2008 - Forcasts of a looming recession - that turned out to be much worse than predicted. Inflation had dropped from 5.4% to about 1%
Fed Funds target was reduced to 1%

FOMC Dec 2008- Unemployment was 6.7% , 500,000 jobs had recently been lost. Inflation had dropped to less than 1%.

Fed Funds target dropped to 0%

It seems that one can make a reasonable argument that FOMC policy was incorrect (especially the sterilization activity) or too slow. And one could argue tht the FOMC lacked sufficient clairvoyance of the severity of the looming recession.

But the 2007-2008 FOMC policies do not seem mysterious or unreasonable.

E. Harding writes:

"E. Harding, But that policy led to the current situation, where supposedly the ECB is powerless. Why would they want to do that?

-Presumably, it was a raise rates now so there's more room to cut them in the future (when the inflationary threat had abated) sort of thing.

Maurizio writes:

If the Fed has a mandate on inflation, should it not have an official measure of inflation expectations?

Scott Sumner writes:

Jean, Good points.

Emerson, I'm not so sure the public understands inflation either, especially the distinction between demand and supply side inflation.

A few remarks on your second comment:

1. Yes, rates fell from August 2007 to April 2008, but not because of anything the Fed did. Market forces drove rates lower; the Fed did not inject any new money into the economy during this period.

2. In September 2008 commodity prices were crashing and on the day of the Fed meeting the TIPS spreads showed that the markets (correctly) forecast only 1.2% inflation over the next 5 years. The Fed is not supposed to be backward looking, but rather to set policy based on where they think the economy is going in the future.

If a rate increase was justified back then based on past inflation, then the Fed has no basis for raising rates anytime soon, as today inflation is running far below target.

E. Harding, If you raise rates now then you reduce the Wicksellian equilibrium rate, which means you have LESS room to cut rates in the future.

Maurizio, Good question.

JP Koning writes:

"When economists are confronted with this fact they suggest that sharply negative interest rates on reserves would depress bank deposit rates so low (so far negative) that the public would pull money out of the banking system, and hold it as currency."

That's when the Buiter/Kimball/Eisler plan can be implemented, forestalling the race into cash.

E. Harding writes:

"If you raise rates now then you reduce the Wicksellian equilibrium rate, which means you have LESS room to cut rates in the future."

-I don't think the ECB considered that. That's something that goes over most people's heads.

Scott Sumner writes:

JP, Yes, that would work, but I'm opposed to it anyway. It would not be needed if we had strongly negative rates on reserves, and paper currency is a very useful asset to society.

E. Harding, Yes, but the ECB is not "most people" and I'd expect more from them.

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